“Value” Vs. “Investment”* in Utility Service Rates
Two Standpoints Considered as Basis in Establishment of Equitable Rates—Example Cited to Prove Fallacy of Rates Based on Value
THE commonest method heretofore adopted by courts when valuing utility properties has been the so-called cost of reproduction-less depreciation-plus going value method. For the purpose of this discussion it is sufficient to speak of “cost of reproduction.” When changes in prices yielded a wavy line up and down, above and below, a fairly horizontal average line parallel to the axis of years, in a diagram, it made comparatively little difference whether original cost to date or reproduction cost was used as the basis of value.
Properties usually being built piecemeal—the actual investment would be made partly in times of high prices and partly in times of low prices, so that the original cost would tend to be a better basis of value than a reproduction cost since it would reflect the effect of prices averaged over a period of years. A reproduction cost estimate made during a period of low prices would deprive the owner of somewhat of his investment, whereas if the estimate were made during a period of high prices something would be added to the investment. Rates for service being based on either one would be likely soon to become inequitable because of the certain change in costs either up or down that would follow soon after the valuation.
Valuations made every few years would be likely to be made sometimes during high prices and sometimes during low prices and so the general average might not be far from fair if made on a reproduction basis. But it would seem to be plain that during a considerable number of years preceding the recent war, original cost to date—actual or estimated actual reasonable investment—was likely to give a fairer basis for determining value than reproduction cost.
Reproduction Costs Nearly Double
Now the situation is changed. Prices are decidedly higher than before the war, and what seemed to be fair then may be questioned now. The reproduction costs of certain utility properties are now nearly or quite twice the original investments made prior to the war. What shall be done now? Is reproduction cost the fairest basis of value now?—Or, is original actual or estimated actual reasonable investment still the better basis? It is asserted with some confidence that the real investment, as nearly as that can be obtained, is still the fairest and best basis for rate making, and that such allowance as must be made for the changed conditions should be in the rate of return.
These properties last for many years during which there may be great fluctuations in costs of construction, and the one stable thing is the investment. It would seem to be the logical thing on which to base rates. But the return rate should vary with considerable or long time variations in costs and the worth of money. An attempt will be made to point out some difficulties and inequities that result from varying value with varying cost prices. Depreciation accounting will be used for this purpose. Assumptions made will be violent for simplicity of computation. Effects of the application of principles will be emphasized by this procedure.
* In this paper, excerpts from which are presented, it having been read before the annual convention of the Iowa Section, A. W. W. A., investment means the actual or estimated reasonable cost of creating a return earning utility property. It is expressed in money.
An Example Cited
Let an investment of $100,000 create a property. Let the depreciation allowance that should be included in annual operating expense and credited to depreciation reserve be based on the cost (or investment) and be such as to provide a sum equivalent to the cost of the physical property when it is retired—varying sums for varying items. Let a particular item costing $100 be considered to be the only depreciating item. Let it be assumed that within the first year—before an annual charge for depreciation is made—in connection with a rate case a court, finding costs doubled—as they are right now— places a value of $200,000 on the physical property, increasing the value of the particular item to $200. A few years later the $100 item goes out of service while prices are still high. It will require $200 to replace the retired item with another like it.
If the item has lasted its estimated life, there will be, in accordance with the assumptions made, $100 in the depreciation reserve either in property or cash, to reimburse the owner for his outlay now used in the service of the public. But the court has raised the value of this item to $200. If this $200 is charged off, the owner loses $100 of the value the court has given him, and to bring the value back to $200,000 he must find $100 of new capital to add to the $100 in the reserve, with which to purchase the replacing item. When the item is in place the value of the property stands as before at $200,000, but the owner has had to invest $100 more than his previous investment to maintain the value of that investment as fixed by the court.
As an Accounting Matter
On the other hand, as an accounting matter, let the process be as follows: After the decision of the court the property value is written up 100% to $200,000. When the item considered is retired, $100 instead of $200 is written off, leaving $199,900 in the property. Then the new item is added and $200 is written on. The result is a property value of $200,100, or the value given by the court plus the extra $100 of new capital invested by the owner. The owner is protected in his value as fixed by the court and his additional investment. And yet we have exactly the same property that was recently valued at $200,000, now carried at $200,100.
Something seems to be wrong with both of the foregoing results and there are those who say—“why, of course—the depreciation allowance should be based on the reproduction cost—the cost of the replacing item— not that of the original item.” Let this be assumed to be true—and for simplicity let it be assumed that the higher cost of the replacing item is known in advance so that at the time the old item goes out of service the cost of the new item has been accumulated in the reserve.
The situation will then be as follows: When the court raises the value to $200,000 the property will be written up 100%. When the item under consideration goes out of service, its new value of $200 is written off, and the cost of the new item, $200, is written on—the whole $200 being found in the reserve. No new capital is needed to maintain the $200,000 value of the property. This seems to be just as it should be. But what has happened? And what is going to happen from now on? The original item cost the owner $100; the depreciation reserve collected from the public amounts to $200, sufficient to purchase the new item; so far as this item is concerned, then, the public will be called upon not only to pay interest or return on the appreciated value fixed by the court, but also to give the owner the actual cash representing this appreciation, which it has done by its payment in operating expenses to the depreciation reserve, and thus contribute capital to the enterprise and pay a return on its own contribution. This certainly seems not right.
What Happens with a Falling Market
The foregoing examples seem to show the inconsistencies attending the handling of depreciation allowances in connection with legally determined value based on a reproduction cost and a permanently rising market. What happens with a falling market that is to be experienced in the reasonably near future and is even now in evidence?
It will be assumed first, as before, that depreciation allowances to the reserve are based on original cost. It will be assumed that a property costing $200,000 is almost immediately valued by a court on the basis of reproduction, at $100,000, the one small depreciating item that cost $200 being valued at $100, and the replacing item is to cost $100.
When the original item goes out of service, either $200 or $100 is to be written off and the cost of the new item, $100 is to be written on. The sum of $200 has accrued in the reserve paid in by the public through charges to operating expense. Then the transaction may be as follows: When the court renders its decision the property is written down 50% to $100,000. When the item considered goes out of service, its cost, $200, accumulated in the reserve, is written off, leaving $99,800, in the property. The cost of the new item $100 is then written on leaving the property statement at $99,900 physical property and surplus of $100 transferred from the reserve, making a total of $100,000. But the surplus may be distributed to the owner, and to essentially the same property that the court valued at $100,000 there will then attach a value of only $99,900.
If only the reduced value of the item, $100, is written off and the cost, $100 of the new item is written on, the property remains at $100,000 value, but there is still $100 in the reserve that may be distributed to the owner.
Now if the reserve has been established on the basis of the cost of the new item then only $100 would be in the reserve; $100 would be written off for the retired item and on for the new item and there would be no disturbance in the accounts, but the owner will have lost half of his original investment.
Loses an Investment Made in Good Faitih
Perhaps this is not more than he should expect after such a fall in prices as must have occurred to make the reproduction cost half the original cost. His loss occurred when the court made its ruling. But he would have lost nothing if he had put his money in a savings bank, and it seems hardly fair that the investor in a permanent public service property should lose a considerable part of his investment made in good faith and of necessity in a time of high prices—as is the case just now with all of the necessary extension work going on, any more than it seems fair that the public should contribute capital to the enterprise when costs advance, and then pay return on that capital.
Indeed it seems unfair to both public and owner alike that the value of a property used to give a public service should depend on the market price of the items, material and labor, that have entered into its composition. It is not these items that the company owner is selling, it is service that these items enable him to render that he is selling. As this service costs more or less, the charge for it should be more or less; as the value of the dollar changes, the rate of return on the investment should change.
Utilities in these days are pleading for values based on reproduction costs and are also showing the increased rates charged for borrowed money in an attempt to get higher “fair returns” than formerly and on higher values than the real investment. A recent New Jersey Supreme Court decision seem to be a defense of such pleading. But it is believed to be wrong.
Receives Amount Loaned on Maturity
Neither will he who loans today on a mortgage, or buys bonds of a utility, receive less dollars than he now loans, when after some years his mortgage loan is paid and his bonds mature. The value of the dollar will have increased but the lender will receive just so many dollars as he loaned, no less and, barring the effect of discount, no more.
Indeed, the securities of very few incorporated industries, regulated or unregulated, reflect the change in the value of the dollar. The stocks of a few industries that have been able to make large profits during the war period did advance in value, many of them even much more than the change in the value of the dollar would indicate, but always because of a change in their earnings, never because of a change in the cost of reproducing the physical property that was the instrument with which the management conducted its enterprise. It ought to be clear that the value of a going property is not what it would cost to reproduce that property. Its value is what it can earn at fair charges capitalized at a determined going rate for money providing its earnings are secure for the future.
Item of “Going Value”
Even the item of “going value” is by some engineers being reduced to a quantity said to represent the cost of producing the business of the property, and this definition has been most often apparently in the minds of the courts when writing opinions, although the first decision that included the item did not suggest the idea of cost at all. Engineers not liking judgment guesses and trying always to reduce all procedure to definite formulas, have suggested various ways of finding “going value”—and while the final deliverance of the court is still a judgment guess it is based upon engineer’s testimony which is most often based on an estimate of the cost of developing the business. Again it is cost of the property used in the service of the public that is assumed to be meant by that word value in the historic reference case. Present day costs, then, of doing the things that were done to create the property, both the cost of developing the business. Again it is cost of the producing service, and the cost of developing the working organization, and, curiously enough, the cost of developing a properly remunerative business, not the business enjoyed by the property at the time of valuation but the business that it ought to enjoy predetermined by the engineer before the court has acted, as a step precedent to his estimate of going value, are assumed to be equivalent to value. Very curious procedure—this.
Present Reproduction Costs Not Values
With respect to the physical plant at least, the generally accepted method means, so far as differences between 1914 and 1920 are concerned, during which few years there was little change in method of facilities, original cost to date appreciated to allow for the cheapened dollar. And original cost to date is investment.
Does not it seem to be clear, therefore, that present day reproduction costs of old properties are not their values, nor even the proper bases for estimating fair return at present day high rates?
And even in normal times, if such there be, when market prices are rising and falling alternately, is it the custom of any business to vary its book investment, on which it figures return, from year to year up and down with the change in the prices of the building materials and labor, used in the construction of the plant which it uses in its activities? Not so—Nor should it be so. For practical purposes the investment in a business plant does not vary from year to year with variation in the cost of the items that are included in its construction, however much it may do so in theory. After some years of more or less steady change in value of real estate, that part of the property may be written up or down as the case may be, but the wearing items of machinery are carried at what they cost until they are worn out or disposed of in some other way. But earnings are made to vary so far as possible with the needs of the times.
So would it seem to be proper to do with utility properties. Regulation providing for fair return on the investment, as that is considered in purely private ventures, the rate varying with the needs of the times, should never be deemed to result in the taking of private property without due process of law nor without just compensation.
Investment as a Basis for Earnings
If we would just be fair with ourselves, recognize investment rather than cost of reproduction, misnamed value, as the basis for earnings, make it possible for a utility company to earn such a return as will command capital, varying the rate of return with the necessity of the times; deal with the utility fairly, and require fair dealing from it, we would have less troublesome litigation, less occasion or desire on the part of the utility to use sharp practice to secure fair return for its service, better service and greater contentment and comfort for the public and its utility servants.
It is believed that if utilities are allowed such return rates on their investments, full operating costs, and depreciation allowances, based on investment, there will be little further litigation, the utilities will be satisfied, and the public should be satisfied because it will be paying no more than a fair return on the investment used in its service. There will be no more discussions of “going value” nor arguments as to what shall be included in cost of reproduction. Costly work for lawyers and engineering experts will be minimized. Peace will reign whether prices go up or down.
The city council of Detroit, Mich., has authorized the expenditure of $80,000 to increase the efficiency of the Fairview pumping station. According to Joseph A. Martin, commissioner of public works of the city, the station is only 67 per cent, efficient as it now stands, as only two of the three pumps can be utilized at one time on account of their being but one stack. The appropriation will also include a new method of automatic feed for boilers.